For the third and final article of our WIRE series focusing on Residential Mortgage Backed Securities (RMBS) and Asset Backed Securities (ABS), we wrap it up with their performance.
Having gone through the key characteristics of RMBS notes and some of the key technical terms, we are looking now at how these notes have generally performed over time. Given hundreds of series of notes have been issued over the years, we have limited our focus on tranches that our clients have purchased and are still outstanding. We focus our comments on the 165 RMBS tranches that are currently held by FIIG investors in our database.
1. Rating performance
Credit ratings are designed to provide a relative indication of risks based on a theoretical stress scenario. The highest rating, AAA, is assigned to securities that are expected to survive the harshest of stress scenarios. At the other end of the spectrum, a rating of B would only survive a modest stress environment.
Unlike companies which face risk in both directions that is relatively evenly spread, RMBS usually get better over time. As a general rule, if an RMBS is not actively getting worse, then it’s getting better. RMBS very rarely tread water at the same price. This is driven by both individual features inside mortgages and the structure of RMBS.
At the individual level, if the borrower is staying current on their mortgage, then the amount borrowed is falling, meanwhile the value of the property is likely rising. It’s less certain, but quite probable, that the salary of the borrower is rising too. So after a few years, you have a smaller loan, a higher salary, and a higher property price. That’s a lower-risk mortgage.
On a structural level, RMBS tranches normally improve over time too. Since RMBS repay the most senior tranches over time, every other tranche in the structure is moving to the front of the queue, even if they are not being actively repaid. This reduction from the top also increases the credit enhancement of the remaining tranches, since the same dollar value of credit enhancement is a greater percentage of enhancement.
This is just a general trend, and when there is significant pressure in the mortgage market there can be downgrades – but over time, upgrades are far more common.
The graph below shows, for all the rated notes we have in our custody, how their current ratings compare to where the same notes were rated at issuance. Because the forces working towards upgrades are mostly reliant on time, the longer an RMBS has been on issue, the greater the chance it has been upgraded. Of the 152 tranches for which there is either an S&P or Moody’s rating, 97 tranches have been upgraded and 55 tranches remain at the same level. Importantly, note that no tranches have been downgraded.
Interestingly, an overwhelming majority of transactions issued between 2015 and 2021 have experienced an upgrade since issuance. The 2022 vintage is not performing as well, which we think is linked to the timing. Borrowers who took out mortgages in 2022 will have likely suffered the worst from the combination of house prices falls in late 2022 and the significant increase in interest rates. It’s worth noting that even though the 2022 vintage has suffered on both sides, it’s still getting better – just not as fast as the 2021 and 2023 vintages.
These ratings upgrades can sometimes be very large, see Figure 2. There are three tranches which have been upgraded by eight rating notches, which is the equivalent of moving from BB to AA-. These are all strongly subordinated tranches from old deals. With the passage of time, the subordinated tranches have worked their way to the front of the queue.
As it stands, 64% of the 152 transactions have so far experienced an upgrade, with an average rating uplift of 1.8 notches, which talks to a very strong performance across the asset class (but also our thorough selection process).
2. Principal amortisation
As we discussed in the second article, RMBS transactions are structured to initially have the most senior tranche receive all the principal repayments. Later, once a step-down threshold is met, payments will be more evenly split, often on a pro-rata basis. The tests that determine this change in payment allocation are called a step-down tests, and are effectively a proxy for performance against expectation. If the step-down test is not met, it could be because the transaction hasn’t been performing as well as expected.
There are generally three triggers in a step-down test:
- The payment date has to be a set period after the issue date (usually two years). This clearly is independent of performance.
- The credit support for the most senior tranche should be more than a pre-determined level. This tied to both prepayment rates and performance.
- Arrears must be below a certain threshold. Also very clearly tied to performance.
Taking the second test above, there are generally two reasons this test is not met: first, the speed at which underlying mortgages are prepaid early is lower than originally anticipated. Second, there is a relatively high level of default. In our experience, the second scenario is highly unlikely and would happen only if high arrears have been previously observed. We note that the level of losses on Australian RMBS remains extremely low and have generally been covered by a combination of claims on lenders’ mortgage insurance and excess spread.
As would be expected, once again the older vintages in our portfolio have been paid down more quickly.
Of the 165 series of notes in our custody, 104 notes have already received some amortisation of principal.
3. Price Performance
It should come as no surprise given the ratings performance, but there has also been clear performance in price terms for RMBS in the FIIG portfolio. A small number of issuers have dropped in price very slightly, but most have risen by a small amount, with some having risen by a significant amount.
This is partly related to the effects of timing passing, as we discussed, and partly related to the fact that credit spreads have generally been tightening. As with regular bonds, if the credit spread for an RMBS tightens, the price of the bond will rise.
Figure 5 shows the prices for new transactions, but this is a strong guide for the behaviour of the prices of existing deals too.
4. Conclusion
The discussion here has focused on the performance of RMBS as an investment class. Because of the individual and structural features of RMBS investments, unless the situation is dire, RMBS investments are usually improving. This can be seen on both the ratings applied by rating agencies and the credit spreads over time.
The passage of time also sees RMBS bonds begin to amortise. The FIIG portfolio of RMBS is paying down as expected.
While over the last few years, the residential housing loan market has experienced ups and downs (all within reason), the performance of Australian RMBS transaction has remained very solid and demonstrates the robustness of these structures.